Question

"Fraudulent Financial Reporting"

• As economic crimes increase globally, accounting fraud is consistently in the top three areas according to a global survey reflected in the chapter. Use the Internet or Strayer Library to research a company sanctioned for financial accounting fraud in the past five (5) years. Give your opinion on the situational pressures that caused perpetrators to commit the fraudulent reporting. Assess the opportunities for fraudulent financial reporting and discuss ways the company you researched could eliminate fraudulent reporting

Answer 1

The Standard on Auditing (SA) 240 “The Auditor’s Responsibilities Relating to Fraudin an Audit of Financial Statements” defines the term ‘fraud’ as-

“an intentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage”.Although fraud is a broad legal concept, for the purposes of the SAs, the auditor is concerned with fraud that causes a material misstatement in the financial statements.

Two types of intentional misstatements are relevant to the auditor–

♦misstatements resulting from fraudulent financial reporting and

♦misstatements resulting from misappropriation of assets.

Fraudulent financial reporting involves intentional misstatements including omissions of amounts or disclosures in financial statements to deceive financial statement users.

Fraudulent financial reporting may be accomplished by the following:

Manipulation, falsification (including forgery), or alteration of accounting records or supporting documentation from which the financial statements are prepared.

Manipulation of Accounts:

Detection of manipulation of accounts with a view to presenting a false state of affairs is a task requiring great tact and intelligence because generally management personnel in higher management cadre are associated with this type of fraud and this is perpetrated in methodical way. This type of fraud is generallycommitted:

(a) to avoid incidence of income-tax or othertaxes;

(b)for declaring a dividend when there are insufficientprofits;

(c)to withhold declaration of dividend even when there is adequate profit (this is often done to manipulate the value of shares in stock market to make it possible for selected persons to acquire shares at a lowercost); and

(d)for receiving higher remuneration where managerial remuneration is payable by reference toprofits.

There are numerous ways of committing this type of fraud. Some of the methods are givenbelow:

i) inflating or suppressing purchases and expenses

(ii)inflating or suppressing sales and other items of income

,(iii)inflating or deflating the value of closinginventory;

(iv)failing to adjust outstanding liabilities or prepaid expenses;and

(v)charging items of capital expenditure to revenue or by capitalising revenue expenses.

Why do Management/ Employees commit fraud? What induces Management/ Employees to commit fraud?

Following are certain instances which will help to understand these questions:

♦Financial obligations/ Pressure. ♦Management’s unrealistic goals. ♦Dissatisfied Employees or Lack of motivation among employees.♦Name game (eg. management using power of authority by asking employees to do something illegal).♦Opportunity to commit fraud.

Misappropriation of Assets:It involves the theft of an entity’s assets and is often perpetrated by employees in relatively small and immaterial amounts. However, it can also involve management who are usually more able to disguiseor concealmisappropriations in ways that are difficult to detect.

Misappropriation of assets can be accomplished in a variety of ways including:

♦Embezzlingreceipts(forexample,misappropriating collections on accounts receivable or diverting receipts in respect of written-off accounts to personal bank accounts).

♦Stealing physical assets or intellectual property (for example, stealing inventory for personal use or for sale, stealing scrap for resale, colluding with a competitor by disclosing technological data in return for payment .

A)Risk Factors Relating to Misstatements Arising from Fraudulent Financial Reporting

:The following areexamples of risk factors relating to misstatements arising from fraudulent financial reporting - Incentives/Pressures: Financial stability or profitability is threatened by economic, industry, or entity operating conditions, such as (or as indicated by):

1. High degree of competition or market saturation, accompanied by declining margins

.2. High vulnerability to rapid changes, such as changes in technology, product obsolescence, or interest rates

.3. Significant declines in customer demand and increasing business failures in either the industry or overall economy.

4. Operating losses making the threat of bankruptcy, foreclosure, or hostiletakeover imminent.

5. Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth.

6. New accounting, statutory, or regulatory requirements.

Opportunities:

The nature of the industry or the entity’s operations provides opportunities to engage in fraudulent financial reporting that can arise from the following:

1. Significant related-party transactions not in the ordinary course of business or with related entities not audited or audited by anotherfirm

.2. A strong financial presence or ability to dominate a certain industry sector that allows the entity to dictate terms or conditions to suppliers or customers that may result in inappropriate or non-arm’s-length transactions

. 3. Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate

.4. Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult “substance over form” questions.

The following are examples of risk factors related to misstatements arisingfrom misappropriation of assets-

Opportunities:

Certain characteristics or circumstances may increase the susceptibility of assets to misappropriation. For example, opportunities to misappropriate assets increase when there are thefollowing:

1. Large amounts of cash on hand or processed.

2. Inventory items that are small in size, of high value, or in high demand.

3. Easily convertible assets, such as bearer bonds, diamonds, or computer chips.

4. Fixedassets which are small in size, marketable, or lacking observableidentification of ownership.